When you buy common stock, you're buying a tiny sliver of ownership in the company that issues the stock. Though it might feel good to think, "I own part of a company," most people invest to make money. Your taxable gains from common stock include both price increases and dividends, but the tax code has several favorable provisions that may help you pay less in taxes than if the income came from your salary.
As long as you continue to own a stock, you won't pay taxes on any increases in the stock's value. This is because the IRS only taxes you on realized gains. For example, if you buy a stock for $40 and the price goes up to $50 but you don't sell, you don't have to pay any taxes on that increase -- yet. Similarly, if you don't sell the stock, you can't take a loss for tax purposes if the price goes down.
Taxable Gain Formula
Your gain isn't simply the price of the stock when you sold it minus the price of the stock when you bought it. Instead, you get to increase your cost to buy the stock and decrease your proceeds from selling the stock by the amount of any transaction fees you paid. For example, say you buy $400 worth of stock and pay a $5 transaction fee: Your cost basis is $405. Then, if you sell it for $500 but have to pay another $5 transaction fee, your proceeds are only $495, so your taxable gain is $90 rather than $100.
The other vital piece of information to know when figuring taxes on your common stock is your holding period, or the length of time you owned the stock before you sold it. When calculating your holding period, don't include the day you bought the stock, but do include the day you sold it. If you held the stock for one year or less, it counts as a short-term gain, which is taxed at the same rates as ordinary income. If you hold it for more than one year, it's a long-term gain, which is taxed at lower rates than ordinary income. Tax rates for ordinary income are determined according to your tax bracket, and maximum tax rates for long-term gains change periodically, as published by the Internal Revenue Service.
Common Stock Dividends
Dividends represent payments from the company that issued a stock to its shareholders for owning the stock. These dividends are taxable income, but may qualify for the lower long-term capital gains rate if the dividend is paid by a U.S. corporation, and if you hold the stock for at least 60 days out of the 60 days before and 60 days after the dividend is paid. If you don't qualify, the dividends count as ordinary income.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."